This Backgrounder examines the economics of international investment, the relationship of international investment with international trade, the generally superior efficacy of private capital markets to political control of investment, bilateral investment treaties, the general rules governing foreign companies issuing or listing securities in the United States and what factors warrant legal limits on inbound or outbound investment. It examines the scope of U.S. investment in China and Chinese investment in the United States. It examines current issues related to Public Company Accounting Oversight Board (PCAOB) inspections of Chinese and other foreign accounting firms, proposed restrictions on international index funds and federal employee investments in international securities, and the use of international institutions to foster greater disclosure related to Chinese investment in third countries.

International Investment

International investment,REF like international trade, enhances the well-being of both parties to the transaction.REF There are mutual gains from international investment, just as there are mutual gains from trade. International investment makes capital markets more efficient, promotes innovation and competition, improves productivity, and diversifies risk. In limited circumstances, national security or other considerations may warrant legal constraints on inbound or outbound investments. This is particularly true if investments (1) involve technology with military applications or (2) would facilitate either cyber-attacks or espionage (including industrial espionage) by an adversary or endanger national security by, for example, jeopardizing critical supply chains. Investments in or by countries that are geopolitical rivals like China or Russia or hostile to the United States raise special concerns.

Generally, however, government should not impede foreign investors from investing in the United States or U.S. investors from investing abroad. One should be deeply skeptical of claims by political actors that they can make better investment decisions than private actors risking their own money. Political actors, like others, often act in their own self-interest and not in the public interest.REF Moreover, no central authority has access to sufficient, timely information to outperform many millions of private actors risking their own money and responding to the information embedded in market prices.REF U.S. policy has been supportive of transnational investment for virtually its entire history. The U.S. has been the beneficiary of inbound investment by foreigners since the early republic.REF

The Capital Account and the Current Account

Any country that runs a capital account surplus must have an equal current account deficit.REF The converse is also true. Any country that runs a current account deficit must run a capital surplus. The United States has had, during various periods in its history, large and sustained capital account surpluses (and the corresponding current account deficit) as foreign capital flowed into the country.REF In the 30-year period from 1790 to 1819, the United States had a merchandise trade surplus in only two years.REF In the 41-year period from 1820 to 1860, the United States had a merchandise trade surplus in only 11 years.REF In the 15-year period from 1861 to 1875, the United States had a merchandise trade surplus in only two years.REF These were generally years of sustained prosperity and growth.

Similarly, the United States has had a merchandise trade deficit since 1971.REF Some of these years were generally prosperous with strong economic growth (1983–1989, 1994–2000), and others were not (1974–1975, 1980–1982, 1990–1991, 2008–2009).REF But policies other than those governing trade and international capital flows were primarily responsible. Targeting the current account deficit or the merchandise trade deficitREF as a policy variable is a mistake.

As of the third quarter of 2019, foreign persons have invested $39.2 trillion in the United States, while U.S. persons have invested $28.3 trillion abroad.REF

U.S. Investment in China and Chinese Investment in the U.S.

According to the Bureau of Economic Analysis (BEA), as of the close of 2018, China accounted for $39 billion of direct foreign investment in the United States, less than 1 percent of the total of $4.3 trillion.REF Others place Chinese direct investment in the United States at the considerably higher levels of $180 billionREF or $140 billion.REF It is not clear why these estimates differ, but even using the higher estimates, Chinese investors account for only about 4 percent of foreign direct investment. Conversely, as of the close of 2018, the BEA places U.S. direct investment in China at $117 billion.REF As of November 2019, China held $1.1 trillion of U.S. Treasury securities.REF As of October 2019, Chinese investors held $1.5 trillion of long-term U.S. securities of all types (7.6 percent of $20.1 trillion in foreign holdings of long-term U.S. securities).REF As of October 2019, Chinese investors held $190 billion of U.S. corporate stock (or 2.2 percent of the U.S. corporate stock held by foreigners).REF About 19 percent of U.S. corporate equities are owned by foreigners.REF

Why Markets Work Better Than Politics

There are six primary (and interrelated) reasons for the superior efficacy of markets over politics as the regulator of economic life:REF

1. Competition increases choice and promotes efficiency,
2. Markets provide better incentives,
3. The price mechanism better allocates scarce resources to meet consumer wants than bureaucracy or politics,
4. Markets and private enterprises better develop and use information,
5. Markets and private enterprises provide greater and more rapid innovation and discovery, and
6. Markets employ distributed planning rather than central planning.

Free markets are much better at providing low-cost, high-quality goods and services that people want than a government-controlled economy. To the extent that government interferes with market processes and substitutes political control for unimpeded markets, economic performance will decline.

Politicizing Investing

Free capital markets allocate investment resources to where market participants believe they will earn the highest rate of return. Apolitical capital markets result in a more effective use of scarce resources, higher productivity, more innovation, and a higher standard of living for all Americans. Politicizing investment decisions results in squandered resources, reduced productivity, less innovation, and a lower standard of living for the American people. Yet there is a major push by progressives, and some conservatives, to politicize investment decisions.

Progressives seek to politicize investment under the banner of environmental, social, and corporate governance (ESG) criteria; corporate social responsibility (CSR) requirements; socially responsible investment (SRI) requirements; sustainability requirements; diversity requirements; or stakeholder theory. Frequent rhetorical obfuscation notwithstanding, the goal of proponents of ESG, CSR, SRI, sustainability requirements, diversity requirements, or stakeholder theory is not to increase corporate profits but to instead alter corporate behavior by legislative, regulatory, or other means in furtherance of social or political objectives in a way that reduces shareholder returns.

The purpose of businesses is to deploy investors’ capital and employees’ labor in the service of consumer needs and wants with the aim of making a profit. But ESG, CSR, and stakeholder theory proponents are trying to alter the very purpose of businesses. Their aim is to pursue a plethora of social objectives rather than earning profits or meeting consumer wants. This would reduce social welfare. It would make American businesses less competitive and cost workers their jobs. It would make the American economy less efficient and productive, raising prices to consumers. It would make businesses become poor stewards of scarce resources. It would make management less accountable, since the metric of “success” will become extremely amorphous. It would reduce the returns to investors and have an adverse impact on the pension plans and defined contribution retirement accounts of well over a hundred million Americans.

Warranted Limitations on Outbound or Inbound Investment

Most people in the world live under authoritarian governments that inadequately respect human rights.REF A per se legal limitation on investment in or by, or trade with, these countries would have an adverse impact on the U.S. economy, U.S. investors, and U.S. consumers. It would also harm the economy of the other country and make it less likely that democratic institutions will develop. Limiting trade and investment relationships entirely to democratic countries with good human rights records would sever American economic relations with most of Africa, much of Asia, and large parts of Central and South America. The United States should not impose legal limits on investment in or by, or trade with, a country only because its government is not democratic.

Legal limits on investments are warranted if investments involve technology with military applications,REF would facilitate espionage, or endanger national security by, for example, jeopardizing critical supply chains. Investments in or by countries that are geopolitical rivals, such as China or Russia, or are hostile to the United States raise special concerns because these countries may use investments to undermine U.S. national security, and they may be inclined to do so. Restrictions are warranted. But policymakers need to remain cognizant that these restrictions have economic costs and that, particularly at the margins, the costs need to be weighed against the benefits.

Although reforms are appropriate, the U.S. government already has a series of strong national security restrictions on technology transfer and both outbound and inbound investment.REF The Bureau of Industry and Security in the Department of Commerce, the Department of Defense, the Federal Bureau of Investigation, the Treasury Department, and other agencies formulate and enforce these restrictions. Similarly, law enforcement is engaged in enforcing laws against industrial, academic, and traditional espionage.REF The United States and other governments have addressed the security dangers, notably facilitating espionage, of having the Chinese company Huawei build out 5G cell networks or other electronic systems.REF There is increasing awareness that having a large share of critical goods (such as pharmaceuticals) produced in a country that is a geopolitical rival (such as China) poses unacceptable national security risks.REF In many cases (e.g., rare earth minerals), this means removing unwarranted legal impediments to domestic operations.REF Supply chain concerns are substantially diminished if the country in question is an allied country. Policymakers should also guard against those who seek illegitimate protectionist aims in the name of national security. Virtually every lobby in America that is subject to foreign competition will argue that national security objectives would be furthered by restricting that competition. There is a need for Congress to more systematically address the supply chain risk.

Bilateral Investment Treaties

Unless a determination is made that a country is hostile (and therefore inbound or outbound investment is undesirable for foreign policy or national security reasons) or otherwise unlikely to honor treaty obligations, a bilateral investment treaty with that country is desirable. Generally, bilateral investment treaties (1) require that investors be treated as favorably as the host party treats its own investors, (2) establish limits on the expropriation of investments and provide for payment of compensation when expropriation takes place, (3) allow funds to be transferred into and out of a host country without delay at a market rate of exchange, (4) restrict requirements such as local content targets or export quotas as a condition for the investment, (5) allow investors to choose their own management, and (6) give the right to international arbitration for dispute resolution in lieu of the local courts.REF The model U.S. treaty has these provisions.REF As of 2018, there were 2,932 bilateral investment treaties in force globally.REF The U.S. has 42 bilateral investment treaties in force.REF Although negotiations were undertaken during the Obama Administration, the United States does not have a bilateral investment treaty with China.REF

Foreign Securities Issuers in the United States

U.S. securities markets are the largest and most liquid capital markets in the world, accounting for nearly two-fifths of global equity values.REF The U.S. stock market dwarfs the securities markets of most countries. Therefore, access to U.S. capital markets is attractive to foreign issuers.

U.S. securities laws apply only to securities transactions in the United States.REF The Securities Act of 1933REF makes it generally illegal to sell securities in the United States unless the offering is registered with the Securities and Exchange Commission (SEC).REF The Securities Act, however, exempts various securities and transactions from these requirements.REF The most important exemption is the exemption for private offerings. Foreign issuers may make either public or private offerings.REF Making a registered offering in the U.S. (often called “going public”) is a very expensive proposition.REF In addition, the costs of complying with continuing disclosure and other obligations of being a registered, public company are quite high. Regulatory and litigation risks are also much higher for public companies.

The Securities Exchange Act of 1934 established the SEC and sets forth the general rules governing securities exchanges and broker-dealers.REF The New York Stock Exchange (NYSE) has 514 foreign listings and 1,729 U.S. listings.REF It is often not possible as a practical matter for smaller public companies to be cost-effectively listed on national securities exchangesREF such as the NYSE or NASDAQ. Instead, they are more often traded on the over-the-counter (OTC) market.REF Over half of stocks traded on OTC Markets are those of foreign issuers.REF Of the 11,674 stocks listed, 5,253 (45 percent) are from the United States; 2,423 issuers are Canadian; 756 are Chinese; and 197 are from Hong Kong.REF

Regulation S-KREF is the key regulation governing non-financial statement disclosures of public companies (those registered with the SEC). Regulation S-XREF generally governs public company financial statements in registration statements or periodic reports. These two rules, including the various rules and accounting policies that they incorporate by reference, impose the vast majority of the costs incurred by public companies.REF

Public Company Accounting Oversight Board (PCAOB)

The PCAOB is a not-for-profit organization exempt from taxation pursuant to Section 501(c)(3) of the Internal Revenue Code.REF Under the law, it is explicitly not “an agency or establishment of the United States Government.”REF Under Title I of the Sarbanes–Oxley Act of 2002, Congress has delegated regulatory authority to the PCAOB.REF The PCAOB regulates the auditing of any issuer of a registered security, broker or dealer.REF This entails mandatory PCAOB registration by any accounting firm conducting such audits,REF compliance with PCAOB rules and standards,REF and submission to PCAOB inspections and audits.REF Compliance with PCAOB rules is costly. These costs do not increase linearly with size, so compliance costs effectively bar small and medium-size accounting firms from auditing even small public companies. Moreover, the cost of accounting firm compliance with PCAOB rules must be recovered by the accounting firms through higher accounting fees charged to issuers and broker-dealers for audits. This is one reason why the number of public companies in the United States has declined substantially.REF The total number of listed companies in 2016 was approximately 4,300, compared to about 8,100 in 1996.REF This is also why there are calls by Senator Tom Cotton (R–AR) and Representative French Hill (R–AR), among others, to exempt non-custodial broker-dealers from PCAOB audit requirements.REF

The PCAOB requires foreign accounting firms involved in auditing foreign investment firms that list their securities in the United States to register with the PCAOB, to comply with its rules and standards, and to submit to inspections. The PCAOB has had difficulty conducting inspections of PCAOB-registered audit firms in Belgium, China, France, and Hong Kong.REF As of December 31, 2019, 143 Chinese and 45 Hong Kong public companies were affected.REF Together, these firms had a market capitalization of about $1.9 trillion.REF Seventeen PCAOB-registered accounting firms audited these companies.REF In addition, approximately nine Belgian and 20 French public companies are affected by inspection difficulties.REF

The PCAOB and the SEC have noted that it is difficult to enforce U.S. accounting rules and securities law requirements in emerging markets generally (including China).REF They note that U.S.-listed international index funds or country funds that invest in foreign securities and provide U.S. investors with access to foreign capital markets raise all sorts of accounting and disclosure issues. Foreign issuers that have no securities listed in the United States are typically unwilling to comply with U.S. regulations simply because a U.S.-listed fund bought their shares. U.S. regulators should either relax their attempts to extraterritorially apply U.S. accounting rules and disclosure requirements or deny American investors access to funds investing in foreign capital markets.

On June 5, 2019, Senator Marco Rubio (R–FL) introduced the Ensuring Quality Information and Transparency for Abroad-Based Listings on our Exchanges (EQUITABLE) Act.REF On May 20, 2020, the Senate passed, by unanimous consent, the Holding Foreign Companies Accountable Act, sponsored by Senator John Kennedy (R–LA).REF This bill would require the SEC to maintain a list of issuers whose auditors have not been inspected by the PCAOB, and it would prohibit the trading of these securities either on exchanges or OTC markets after three years unless they are removed from the list. It would also mandate additional disclosure by Chinese issuers regarding the percentage of issuer shares held by the Chinese government, the name of any Chinese Communist Party official on the Board of Directors, and other matters.

The bill would have an adverse impact on Chinese issuers, because it would deny them access to U.S. capital markets unless the Chinese governmentREF and Chinese accounting firms relent to PCAOB inspections. It would also make it extremely difficult for U.S. shareholders of these companies that bought those shares on U.S. markets to sell their shares, since the issuers’ shares may not be traded. They may incur a near total loss.REF There is a certain irony inherent in legislation passed in the name of investor protection that is likely to result in a near total loss for investors. Congress may want to consider giving an explicit cause of action against issuers that listed their securities in U.S. markets but failed to comply with U.S. laws (even if compliance is prohibited by Chinese law).

The core principle underlying the bill is sound. Foreign issuers that list their securities in the United States should comply with the same rules with which U.S. issuers must comply. But Congress also needs to reevaluate the cost and complexity that PCAOB and SEC accounting and audit and governance requirements impose on all public companies. They are too high and are making the public capital markets inaccessible to all but the largest companies.REF

On June 4, 2020, President Trump issued a presidential memorandum that requires the President’s Working Group on Financial Markets to providing recommendations within 60 days for actions by the SEC, other agencies, and the PCAOB.

The TSP, Index Funds, and China

The Thrift Savings Plan (TSP) is a defined contribution retirement savings and investment plan for federal employees and members of the uniformed services. It is similar to a private-sector 401(k) plan. It was authorized by Congress in the Federal Employees’ Retirement System Act of 1986.REF It is managed by the Federal Retirement Thrift Investment Board (FRTIB), a federal agency.REF The members of FRTIB are statutorily required to “discharge their responsibilities solely in the interest of participants and beneficiaries.”REF As of April 2020, TSP assets totaled approximately $600 billion, and retirement savings accounts were being maintained for almost 6 million participants.REF

TSP participants can invest their employee and employer contributions in the following core funds:

• Government Securities Investment Fund (G Fund),
• Fixed Income Index Investment Fund (F Fund),
• Common Stock Index Investment Fund (C Fund),
• Small Cap Stock Index Investment Fund (S Fund), and
• International Stock Index Investment Fund (I Fund).

In addition to these indexed core funds, participants may also invest in five Lifecycle Funds (L Funds). The L Funds are custom target-date funds invested exclusively in the G, F, C, S, and I Funds.REF

In November 2017, the FRTIB decided to change the basis for the I Fund investments from the MSCI Europe, Australasia and Far East (EAFE) Index to the MSCI All Country World ex US Investable Market Index. MSCI is a publicly traded company that, among other things, provides a wide variety of financial indexes that in many cases serve as either the basis for other firms’ securities offerings (usually funds that emulate a given index) or as benchmarks that the performance of mutual funds or exchange traded funds are measured against.REF

The MSCI EAFE Index is an equity index that includes large and mid-capitalization companies across 21 developed country markets, excluding the United States and Canada. It has 915 constituents and covers approximately 85 percent of the free-float-adjusted market capitalization in each country. The country weights for the index are currently Japan 26.42 percent, the United Kingdom 14.48 percent, France 10.62 percent, Switzerland 10.29 percent, Germany 8.8 percent, and other 29.4 percent.REF The MSCI ACWI ex USA Investable Market Index (IMI) captures large, mid- and small capitalization companies across 22 developed country markets (excluding the United States) and 26 emerging market countries. It has 6,573 constituents and covers approximately 99 percent of the global equity investment opportunities outside the United States. The country weights for the index are currently Japan 18.26 percent, United Kingdom 9.8 percent, China 9.6 percent, Canada 6.58 percent, Switzerland 6.44 percent, and other 49.32 percent.REF

By law, the FRTIB is required to “select an index which is a commonly recognized index comprised of stock the aggregate market value of which is a reasonably complete representation of the international equity markets excluding the United States equity markets.”REF It is also required to act solely in the interest of participants and not permitted to pursue social or political objectives.REF The FRTIB, in making the change, wanted to provide TSP participants exposure to the Canadian market, exposure to emerging markets, and more diversified investments.REF It also believed that the IMI better met the statutory charge since it gives exposure to 99 percent of non-U.S. equity markets.

This decision proved to be controversial. For example, on May 22, 2019, Representative Jim Banks (R–IN) introduced the Blocking Investment In Our Adversaries Act, which would prohibit the TSP international index from including “any stock of an entity based in a peer or near-peer competitor, including China or Russia.”REF On August 26, 2019, Senators Rubio and Jeanne Shaheen (D–NH) sent a letter to the FRTIB opposing the change on the grounds that U.S. federal workers should not be investing any of their money in communist China because of national security, human rights, and inadequate financial disclosure concerns.REF On May 11, 2020, Director of the National Economic Council Lawrence Kudlow and National Security Advisor Robert O’Brien wrote to Labor Secretary Eugene Scalia opposing the move on national security and humanitarian grounds and because of Chinese non-compliance with PCAOB inspection requirements.REF

On May 13, 2020, the FRTIB announced,

Due to a meaningfully different economic environment related in large part to the impact of the global COVID-19 pandemic, as well as the nomination of three new FRTIB Board Members, pending further study, the FRTIB Board is delaying the implementation of the I Fund Benchmark change to the MSCI ACWI ex-U.S. Investible Market index from the MSCI EAFE index.REF

Politicizing retirement investing to achieve political, foreign policy, humanitarian, or social objectives is a mistake. The investments should be made, as the statute requires, to achieve the maximum return for participants. Moreover, this will not be the end of the matter. Progressive administrations will undoubtedly seek to invest the money domestically in indexes that duly account for ESG, corporate social responsibility, or social justice criteria. The Boycott, Divestment, Sanctions (BDS) movement popular in progressive circles will undoubtedly attempt to exclude IsraelREF or other unpopular countries from the TSP funds as they have in many university or church endowments and retirement plans. And once this principle is established for federal employees, there will be no principled reason why federal intervention in private retirement funds will not be forthcoming. Politicians who feel they have the right to direct federal workers’ retirement accounts will most likely feel just as justified in directing private workers’ retirement funds. Politicizing investment decisions, however, hurts not only investors but also the economy generally by allocating investment less efficiently to the detriment of productivity and workers’ wages.

Ensuring Chinese Debt Transparency Act of 2020

The Ensuring Chinese Debt Transparency Act of 2020REF passed the House of Representatives on March 2, 2020, by a vote of 356–0.REF The bill instructs the U.S. executive directors at the International Monetary Fund, the International Bank for Reconstruction and Development, the European Bank for Reconstruction and Development, the International Development Association, the International Finance Corporation, the Multilateral Investment Guarantee Agency, the African Development Bank, the African Development Fund, the Asian Development Bank, the Inter-American Development Bank, the Bank for Economic Cooperation and Development in the Middle East and North Africa, and the Inter-American Investment Corporation to “use the voice and vote of the United States at the respective institutions to seek to secure greater transparency with respect to the terms and conditions of financing provided by the government of the People’s Republic of China to any member state of the respective institution that is a recipient of financing from the institution.” It also requires follow-up reports to Congress. This reflects concern by the U.S. government that China is making unsustainable loans or investments with the aim of “taking possession of sovereign assets as collateral”REF or otherwise using non-commercial or irresponsible financing practices to achieve political objectives.

Conclusion

International investment, like international trade, enhances the well-being of both parties to the transaction. International investment makes capital markets more efficient, promotes innovation and competition, improves productivity, and diversifies risk. In limited circumstances, national security or other considerations may warrant legal constraints on inbound or outbound investments.

Generally, however, government should not impede foreign investors from investing in the United States or U.S. investors from investing abroad. One should be deeply skeptical of claims by political actors that they can make better investment decisions than private actors risking their own money. Politicizing investment decisions results in squandered resources, reduced productivity, less innovation, and a lower standard of living for the American people. Yet there is a major push by progressives—and some conservatives—to politicize investment decisions. Political actors, like others, often act in their own self-interest and not in the public interest. Moreover, no central authority has access to sufficient, timely information to outperform many millions of private actors risking their own money and responding to the information embedded in market prices. U.S. policy has been supportive of transnational investment for virtually its entire history. The U.S. has been the beneficiary of inbound investment by foreigners since the early republic.

Most people in the world live under authoritarian governments that inadequately respect human rights. A per se legal limitation on investment in or by, or trade with, these countries would have an adverse impact on the U.S. economy, U.S. investors, and U.S. consumers. It would also harm the economy of the other country and make it less likely that democratic institutions will develop. Limiting trade and investment relationships entirely to democratic countries with good human rights records would sever American economic relations with most of Africa, much of Asia, and large parts of Central and South America. The United States should not impose legal limits on investment in or by, or trade with, a country only because its government is not democratic.

Legal limits on investments are warranted if investments involve technology with military applications, would facilitate espionage, or endanger national security by, for example, jeopardizing critical supply chains. Investments in or by countries that are geopolitical rivals, such as China or Russia, or are hostile to the United States raise special concerns, because these countries may use investments in the United States or in their countries to undermine U.S. national security and may be inclined to do so. Restrictions are warranted. But policymakers should remain cognizant that these restrictions have economic costs. Policymakers should also guard against those who seek illegitimate protectionist aims in the name of national security.

The PCAOB requires foreign accounting firms involved in auditing foreign firms that list their securities in the United States to register with the PCAOB, to comply with its rules and standards, and to submit to inspections. The Senate-passed Holding Foreign Companies Accountable Act would have an adverse impact on non-compliant issuers because it would deny them access to U.S. capital markets unless the Chinese government and Chinese accounting firms relent to PCAOB inspections. It would also make it extremely difficult for U.S. shareholders of these companies that bought those shares on U.S. markets to sell their shares, since the issuers’ shares may not be traded. They may incur a near total loss. The core principle underlying the bill is sound. Foreign issuers that list their securities in the United States should comply with the same rules with which U.S. issuers must comply. But Congress should also reevaluate the cost and complexity that PCAOB and SEC accounting, audit, and governance requirements impose on all public companies. They are too high and are making the public capital markets inaccessible to all but the largest companies.

Politicizing retirement investing to achieve political, foreign policy, humanitarian, or social objectives is a mistake. The investments should be made, as the statute requires, to achieve the maximum return for participants. Moreover, this will not be the end of the matter. Progressive administrations will undoubtedly seek to invest the money domestically in indexes that duly account for ESG, CSR, or social justice criteria. The BDS movement will undoubtedly attempt to exclude Israel or other unpopular countries from the TSP funds as they have in many university or church endowments and retirement plans. And once this principle is established for federal employees, there will be no principled reason why federal intervention in private retirement funds will not be forthcoming. Politicians who feel they have the right to direct federal workers’ retirement accounts will most likely feel just as justified in directing private workers’ retirement funds.

David R. Burton is Senior Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy, of the Institute for Economic Freedom, at The Heritage Foundation.